Student Loan Borrowers Leaving Lots of Money on the Table

"I'm still trying to get my head around some concepts that I heard today," said Rep. Raúl Grijalva (D-Ariz.), a member of the House Workforce and Education Committee, "that irrespective of the amount of money you borrow or the interest rate, that you'll still end up paying the same amount."

"Wow, somehow that doesn't seem possible," said Republican Rep. John Kline of Minnesota, the committee chairman.

The committee members were responding to testimony given last month by Jason Delisle at a March 13 congressional hearing in which Delisle spoke about the Department of Education's income-based student loan repayment (IBR) program.

But Grijalva and Kline aren't the only ones unaware of the benefits of IBR. As it turns out, they are in the majority, a fact that prompted the White House to issue a 2012 statement concluding that "Too few responsible borrowers are aware of their repayment options."

Indeed, at a time when Congress is debating whether to raise student loan interest rates and defaults continue to skyrocket, IBR—enacted as part of the College Cost Reduction and Access Act of 2007 under the Bush administration and expanded under President Barack Obama—remains a largely obscure concept for many cash-strapped college graduates.

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"We know many graduates are concerned about their ability to repay student loans in the current economic environment," Education Secretary Arne Duncan said at the inauguration of the program in 2009. "This new plan addresses the issue head-on by giving them the option of a monthly payment tied to their income."

Still, according to DOE data as recent as January, a little more than 2.3 million borrowers had applied for IBR nationally, a small fraction of the estimated 38 million Americans with outstanding student loan debt. Over 1.6 million, or 65 percent, of those applicants have been enrolled in the program, with another 20 percent, or approximately 460,000 applicants, awaiting review.

Such low figures have shone a glaring spotlight on the DOE's failure to sufficiently educate borrowers, according to consumer advocates like Mark Kantrowitz, the publisher of FinAid.org and FastWeb.com, who estimates that as many as 3 million students could qualify.

"Every time a borrower takes out a student loan," Kantrowitz said, "they should be made aware of all of their repayment options, including income-based repayment."

Under IBR, a borrower's monthly payments are capped at a percentage of their discretionary income in an effort to relieve the stress borne by those with high debt-to-income ratios. So a borrower's average monthly payments aren't based on standard metrics such as the original principal borrowed and the interest rate associated with a given loan—effectively making interest rates irrelevant.

"Your loan is forgiven before the interest rate is ever a factor," said Delisle, director of the Federal Education Budget Project at the New America Foundation, a Washington think tank that focuses on a host of public policy issues, including education. "The United States now has the most generous student loan repayment program in the world."

As long as your monthly payment under a standard repayment plan is more than what you would pay under IBR, you are eligible to enroll. The only stipulation is that your loans qualify for IBR. Only Stafford, Grad PLUS and certain consolidated loans are suitable. Perkins loans and private student loans are not.

Tens of Thousands of Dollars in Loans Forgiven

Under the program, borrowers can qualify for the Old IBR program, which applies to anyone who took out their first student loan on or prior to October 1, 2007, or the New IBR program, which applies to all initial federal loans issued after that date.

The Old IBR has a 25-year repayment period and caps a borrower's monthly payments at 15 percent of discretionary income, while the New IBR, part of Obama's 2010 Health Care and Education Reconciliation Act, cuts a borrower's monthly payments by a third—from 15 to 10 percent—and condenses the repayment period from 25 to 20 years.

Most important, both the old and new programs allow a discharge, or forgiveness, of any remaining student loan balance after the repayment period has ended, which means that many borrowers stand to see tens of thousands of dollars in student loan debt forgiven, according to Delisle.

To give borrowers a sense of how much savings they can expect to gain under IBR, Delisle and his colleagues devised an Income-Based Repayment Calculator that can easily be downloaded from the organization's website. Using the calculator, a borrower with a mixture of federal student loans—subsidized or unsubsidized—can get a rough estimate of their accrued savings over time.

Take, for example, a borrower with $70,000 in combined undergraduate and graduate school student loan debt that gets a job upon graduation making $40,000, with a 2.5 percent annual increase. According to the calculator, such a borrower can expect to pay back between $550 and $600 each month under the government's standard 25-year extended repayment plan.

During the repayment period, such a borrower would pay a whopping $165,000 in combined student loan principal and interest—or a 135 percent increase over the original loan borrowed.

However, under the old program, that same borrower would see the monthly payment fall to approximately $300 a month and the total repayment amount fall to $98,000 over the same 25-year repayment period, with any remaining unpaid balance discharged. This means that signing up under the Old IBR plan would save this borrower more than $65,000 in principal and interest.

And if that's not generous enough, newer borrowers, or those who qualify for the New IBR with the shorter 20-year repayment term, can expect their monthly payments to fall to between $160 and $170 a month, with the total amount repaid falling to $49,000.

So under the new, more generous IBR program, our aforementioned borrower could literally receive a six-figure loan forgiveness, or about $115,000 in this instance.

"So under either the new or old income-based repayment plans, you may never actually pay any of the original principal borrowed," said Delisle, which is ultimately what makes the interest rate on the loan moot.

So any qualified borrower who's not enrolled in the program is effectively leaving a rather sizable amount of money on the table.

Income-Based Repayment's Biggest Beneficiaries

And IBR's benefits don't stop there. The program also includes public service loan forgiveness, which discharges the loans of any student loan borrower who commits to working for 10 years in public service, nonprofit, or government—low-paying sectors ordinarily—after that time.

"If you plan on doing any kind of public service, nonprofit or government work," said Delisle, "then you should borrow as much money as [your school] will possibly let you."

Indeed, the IBR savings that accrue to borrowers who pursue such career paths can be mind-boggling.

Take for instance our example student who owes $70,000 and goes to work making $40,000 a year upon graduation. Under the Old IBR's public service forgiveness option, that student would ultimately repay just $33,000, or less than half of the original principal.

And that figure falls to an unfathomable $22,000 if the borrower qualifies for the New IBR.

If that student were to attempt to pay off his or her loans using a standard 10-year repayment plan not under IBR, he or she would end up paying back $97,000.

Also, unlike either IBR program, which allows the government to tax any amount discharged at the end of your 25- or 20-year repayment term, any remaining balance under the public service loan forgiveness program is tax exempt.

"We're getting talented people working as public defenders and prosecutors that we might have lost to the private sector," said Kantrowitz.

But it's not only those who work in public service professions who benefit disproportionately from IBR, according to Delisle. "The program provides far more benefits to those at the higher end of the income spectrum," he noted, such as doctors, lawyers and those with MBAs.

"While the program provides very large subsidies when your income is low," he said, "it really doesn't claw those benefits back if your income ends up being high," meaning graduates with large sums in student loan debt—ordinarily graduates of medical, law and business schools, who typically make higher starting salaries—ultimately end up benefiting overwhelmingly from IBR.

So a student who graduates from Harvard Law School with $150,000 in student loans and goes to work at a law firm making close to six-figures annually still stands to receive a "windfall"—as Delisle calls it—of six-figures in principal and interest forgiven on average.

This is because the incremental cost of borrowing an additional dollar under IBR gets smaller as the total amount borrowed rises, regardless of the borrower's salary.

This is one of the few inefficiencies of an otherwise sound program, according to Delisle.

"Claw backs" from the IBR benefits of high-income earners, he suggests, could instead be used to subsidize the cost of undergraduate education nationally in the form of need-based Pell Grants.

Inside the Mind of the Student Loan Borrower

According to Kantrowitz, a lot of the rising rates of student loan defaults have to do with the "psychology" of the typical borrower.

Many of them are intimidated by "the prospect of being on a repayment plan for over two decades," he said, choosing instead to apply for postponement alternatives like deferments and forbearances until those options run out and they're left with no other option but to default.

So although a borrower with a high income-to-debt ratio may stand to benefit the most from programs such as IBR, they are often the least likely to apply, seeing repayment as a financial albatross.

But a process of avoidance, whether intentional or otherwise, can be costly, said Kantrowitz. "If you default on your loans, the 15-percent wage garnishment the government can take from your paycheck is greater than what you would pay under an income-based repayment plan."

He also believes the Education Department should re-evaluate the way collections agencies are compensated for collecting outstanding student loan debt on the government's behalf. According to Kantrowitz, collections agencies have incentives to get as much money from a borrower as possible. "So the first option they're going to offer you isn't income-based repayment," he said.

"Their incentives aren't necessarily aligned with protecting borrowers' interests," said Persis Yu, an attorney with the National Consumer Law Center. "The Higher Education Act is a very complicated statute, and debt collectors aren't necessarily in the best position to explain options to borrowers."

Still, changes to the way the Education Department facilitates IBR are evident, from making it a mandatory part of the student loan exit interview process to making it easier to enroll. Last September, the department rolled out an online IBR application that reduces the time and paperwork it takes borrowers to sign up.

Such changes, among others, are welcomed by Delisle and other consumer advocates, offering students greater flexibility in choosing a career and paying for their education.

Because of IBR there's "no reason not to pursue a graduate degree and borrow to pay for it," said Delisle.

"There's only upside, because the government is stepping in to pick up any downside risk or loss," he said. "It's mind-blowing how generous income-based repayment really is."

Others, such as Draeger, agree with Delisle's assessment. "Why does anybody default in the day and age of income-based repayment?" he asked.